A few weeks ago, we compared a traditional IRA to a Roth IRA in our weekly blog. While there are a number of factors that influence this decision, our focus is primarily on the tax effect. In this post, we will continue our discussion.
(If you missed the first two parts, you may want to read them first: Traditional IRA vs. Roth IRA: What’s Best? and Traditional IRA vs. Roth IRA: What’s Best? Pt. 2—The Details)
Congress and the Roth IRA
In 1997, Congress unveiled the Roth IRA as an alternative to the traditional IRA. The tax-free withdrawal aspect of the Roth, plus the ability to convert a traditional IRA to a Roth IRA and spread the tax liability over a four-year period, was quite appealing to many investors.
I suspect Congress created the Roth IRA to increase tax revenue as people converted their traditional IRAs to a Roth. In addition, since contributions to a Roth are after-tax dollars, it makes sense that tax deductions would decrease, again, boosting tax revenue.
Which is better: the Roth or the traditional IRA? I used to believe the Roth was best, especially for younger investors. After a thorough examination, I have a very different opinion.
The table below contains a recap of the major assumptions during the contribution and withdrawal phase (25 years each – 50 years total). The analysis assumes the investor begins with $10,000 before taxes.
In the chart that follows the table, in the traditional IRA (blue line), the entire $10,000 is invested each year (pre-tax) and withdrawals are increased to $13,889 to provide $10,000 after tax. Roth-1 (black line) assumes there are no taxes during the contribution phase and the full $10,000 is invested each year. Roth-2 (purple line) assumes a 28.0% combined tax rate during the contribution phase, thus reducing annual contributions to $7,200. Finally, even though this taxpayer’s income will prohibit a Roth contribution, Roth-3 (red line) assumes a 38.9% combined tax rate during the contribution phase, reducing the annual investment to $6,110.
In all Roth scenarios, since qualified withdrawals are income tax free, the total annual withdrawal is $10,000. In short, the traditional IRA has the advantage over Roth-2 and Roth-3 during the contribution phase and all Roth IRAs have the advantage during the withdrawal phase.
The graph below shows the value of each IRA at years 25, 35, 45, and 50.
Traditional IRA vs Roth IRA
Because Roth-1 assumes no taxation during the contribution phase (i.e., total annual contributions are $10,000), the traditional IRA and Roth-1 reach the same value at the end of year 25 ($789,544). After this point, the Roth has the advantage because withdrawals from a traditional IRA must be increased to $13,389 to provide $10,000 after tax.
The difference in their value in year 35 is $56,337, or 3.7%. The percentage spread between Roth-1 and the traditional IRA at the end of the analysis (year 50), is only 6.5%.
Of course, this assumes there are no taxes during the contribution phase, which is unrealistic.
As the chart illustrates, Roth-2 and Roth-3 significantly lag the traditional IRA. After 50 years, Roth-3 is more than $1.8 million, or 41.4%, behind the traditional IRA and Roth-2 is more than $1.2 million, or 28%, behind.
Even though the traditional IRA seems to be a better choice in most situations, it is important to acknowledge a few unique aspects of the Roth IRA. First, you may contribute to a Roth after age 70 ½ if your earned income is equal to (or greater than) the annual contribution limit. In addition, the Roth IRA is not subject to the RMD rules while the owner is alive. Finally, a tax loss is possible when you withdraw from a Roth IRA in certain situations.
Although there are some advantages with a Roth IRA, the traditional IRA is the better choice in most cases. However, if future tax rates are drastically higher than tax rates during the contribution phase, and the contribution period is long enough to allow the interest to become a larger portion of the total value, the Roth may be a better option.
Until next time, thanks for reading and have a great week!
NOTE: If you disagree with the premise of reducing annual contributions to a Roth IRA based on the tax bracket, and believe the full $10,000 should be invested, you would need to create a second account for the traditional IRA, funded with the annual tax savings, and combine its value with the traditional IRA account to be fair.